Bernanke signals new approach to bubbles

17 October 2008 — 8:20am

Federal Reserve chairman Ben Bernanke has signalled an end to the Fed's decades-old aversion to interfering with asset-price bubbles as the financial crisis reshapes some of the central bank's most firmly held views on regulation and monetary policy.

Officials should review how supervision and interest rates can tackle the ''dangerous phenomenon'' of bubbles in housing, stocks and other assets that risk bringing the entire economy down, Bernanke said yesterday. He also warned that banking may be concentrated in too few hands even as mounting losses and corporate failures push lenders into mergers.

''There is no doubt that as we emerge from the current crisis that we are all going to look very hard at that issue and what can be done about it,'' he told the Economic Club of New York in response to a question after a speech.

''It's a big change,'' said Ross Levine, a professor of economics at Brown University in Providence, Rhode Island. ''It brings up one of the major failures underlying the crisis.''

Bernanke, a scholar of the Great Depression, is contending with an increasingly fragile economy. Hours before he spoke, the Commerce Department reported that retail sales fell the most in three years last month. The decline was the third in a row, a retrenchment unseen since 1992, and contributed to the biggest slide in US stocks since the 1987 crash. The Fed's Beige Book regional survey showed activity deteriorated in September.

Anticipating more cuts

The data led traders to bet the Fed will reduce rates again after last week's cut in tandem with the European Central Bank, Bank of England and three other central banks.

''It is a good thing the nation's chief economist is an avid student of the causes and roots of the Great Depression because it will take all the Fed's skills and tools and imagination to get us out of this financial mess,'' said Chris Rupkey, chief economist at Bank of Tokyo-Mitsubishi UFJ.

Government efforts to calm financial markets and stem the credit crisis probably won't result in an immediate economic rebound, Bernanke said. Bernanke and Treasury Secretary Henry Paulson announced a day earlier that the government could inject $US250 billion into thousands of banks.

''Stabilization of the financial markets is a critical first step, but even if they stabilize as we hope they will, broader economic recovery will not happen right away,'' Bernanke said in his speech. ''Economic activity will fall short of potential for a time.''

Housing epicentre

Bernanke reiterated that the decline in house prices and surge in foreclosures remains the ''primary source of weakness'' and indicated he was open to further steps to stem the slide.

The central bank has been criticized for fueling the housing boom that later turned to bust by keeping interest rates too low for too long in the first half of this decade. Fed officials have spent years wrestling with how to prevent bubbles without damaging the economy, and few have come up with an answer.

For two decades, the ruling philosophy was that of former chairman Alan Greenspan. ''It is far from obvious that bubbles, even if identified early, can be pre-empted at a lower cost than a substantial economic contraction and possible financial destabilization,'' Greenspan told the American Economic Association in 2004.

Rethinking approach

His successor, Bernanke, and his team now find themselves reconsidering their approach to everything from regulation to state ownership. The collapse of the US subprime-mortgage market has led to more than $US600 billion in writedowns and credit losses since the start of 2007, pushing Lehman Brothers into bankruptcy, forcing Merrill Lynch to merge with Bank of America and turning Morgan Stanley and Goldman Sachs. into bank holding companies. The first investment bank to fall this year was Bear Stearns, which the Fed forced into the arms of JPMorgan Chase.

Now, policy makers will toughen their response to ''excessive leverage,'' give more weight to financial stability in economic analysis and examine ways to strengthen the system of trading and settlement behind complex derivative securities, Bernanke said.

Bernanke has pushed the limits of the Fed's authority to create several unprecedented lending channels. Still, damage from the credit crisis has spread from mortgage lenders, commercial banks, securities firms and the biggest US insurer to companies involved in manufacturing and services.

'Too big to fail'

The US faces ''a very serious too-big-to-fail problem,'' in which the insolvency of a large financial company could threaten a market collapse, Bernanke said in reply to an audience question. ''There are too many firms that are in some sense systemically critical.''

The bankruptcy of Lehman Brothers on September 15 increased fears among investors that their short-term loans might not be repaid. Short-term money market rates, such as the market for dollar loans known as Libor, or the London interbank offered rate, soared. The three-month Libor rate stood at 4.55% yesterday.

The Lehman failure was so disruptive that the central bank decided to protect creditors against a similar collapse of American International Group Inc. The firm accepted an emergency $US85 billion loan from the Fed on September 16.

US central bankers have used some five new programs, many erected under emergency powers, to pump billions in temporary dollar loans into a financial system where many banks have curtailed overnight lending out of concern they won't be paid back.

''Ultimately, the trajectory of economic activity beyond the next few quarters will depend greatly on the extent to which financial and credit markets return to more normal functioning,'' Bernanke said.